A recent customer awareness campaign by the FSA (Financial Services Authority, in theUK), concluded that 61% of respondents are not willing to take any risk with their investment. In fact, since a similar survey was undertaken in 2010, respondents have become slightly more risk averse.

“This is not surprising, given the uncertainty surrounding financial markets”, the FSA says.

Given these results it is likely that a lot of people are unlikely to consider investing anywhere other than some form of bank deposit accounts. This reminds me of a presentation, by a fund manager, a number of years ago.

He had a wealthy potential client that said that he was risk averse and would only consider investing in bank deposits as he believed that this would make him more profit than actively investing in the markets. The response of the fund manager was to say “I admire your extremely aggressive approach to managing your money!”

The response was something like “Huh? What do you mean?”

The fund manager replied “ You are saying that you believe that your short, medium and long term investment objectives are best served by having all your “eggs in one basket” by only considering one type of investment and that it will provide you with better returns than anything else. That is aggressive money management”.

Whilst it was all a bit ‘tongue in cheek’, it does raise interesting issues. Cash deposits provide income, but not capital growth, other investments such as shares provide income and the prospect of capital growth. People know this and yet don’t wish to take the “jump” into equities. However, there is a way to “dip ones toe in the water”. It is known as Unit Cost Averaging”.

Unit Cost Averaging

It is practically impossible to predict the bottom of the market if one wants to invest at the cheapest point. By investing a lump sum, there is a risk that the market will move down straight afterwards and so the timing of investment is difficult if this is to be avoided. However, if investment into the market is gradual by way of regular monthly premiums, the average price paid per investment unit can be lower in falling markets. This can lead to greater potential investment value over time, the greater the market volatility, the greater the potential benefits for regular savers.

How does this work in practice?

The chart below illustrates two different notional stock market price scenarios – a market that rises and then falls, and a market that falls before rising. ( Using UK sterling as an example, but the principle is the same for all currencies)

As you can see from the charts (fictional) below

• Regular investments in a falling then rising market show a 20% gain
• Regular investments in a rising then falling market deliver a 12% loss
• A single investment where a lump sum is invested and the market returns to its starting position in either direction delivers no gain at all.

For people that have capital available to invest, it is important that the structure of the regular payments is no more expensive than that for a capital lump sum and that there is flexibility to stop/start/increase/decrease premiums and withdraw capital without penalties.

Summary

• Unit cost averaging is a technique that reduces exposure to falling markets from investing a lump sum. By investing at regular intervals more shares are purchased when share prices are low and fewer shares are purchased when prices are high.
• The investor will be better off in falling markets.
• The investor will be worse off in rising markets.
• Instills a sense of investment discipline which avoids second guessing markets.

‘The policy of being too cautious is the greatest risk of all’-Jawaharlal Nehru

Christopher Lean is a consultant at Square Mile Financial Services (http://www.squaremilefs.com) and an Associate of the Personal Finance Society (Chartered Insurance Institute).